Land market distortions

I have an op-ed in Indian Express today on distortions in India's land markets.

Rising healthcare costs - example of anti-cancer drugs

In the context of rising medical costs without commensurate improvements in health condition, Tim Taylor points to a JEP paper by David Howard, Peter Bach, Ernst Berndt, and Rena Conti on how the life outcomes of anti-cancer drugs has changed with increasing prices in the US market. Their study, which involved studying the pricing trends of 58 anti-cancer drugs (focused on extending survival times for cancer patients) approved for sale in the US between 1995 and 2013, found sharply launch prices with limited increases in life years (estimated from randomized clinical trials or modeling studies that formed basis of FDA approvals).

Their study graphs the treatment-episode costs (in 2013 dollars) vs incremental survival benefits and finds that prices increase by 120% for each additional life year gained or $75000 for each year gained. Further newer drugs are not associated with any increase in survival benefits compared to older drugs.

The second graph plots the drug price per life-year gained (price per treatment episode divided by survival benefits) against the drug's approval date. This shows that drugs price adjusted for benefits and inflation rose by $8500 per year. In other words, patients who paid $54,100 for a year of life paid $139,100 in 2005 and $207,000 in 2013.

While conventional wisdom on drugs pricing focuses on high R&D costs, the authors claims that the real reasons for these large increases with limited benefits may lie elsewhere. They point to reference pricing - the new drug is priced a little higher than its existing competitor - as one contributor. Further, government programs which mandate pharma companies to sell drugs at a discount to certain buyers encourages them to mark-up their sales price for a higher negotiations benchmark.

At a fundamental level, as the authors of the paper claim, the fundamental challenge in managing health care costs is about how physicians, insurers, and regulators should approach "treatments that are more costly but also offer small incremental benefits". 

More on premature de-industrialization

Dani Rodrik has a new working paper on premature de-industrialization that  highlights the challenge facing countries like India which have staked its growth on manufacturing. He examines the trends in the shares of manufacturing employment (manemp), nominal manufacturing value added (nommva), and real manufacturing value added (realmva) for a sample of 42 developed and developing countries over a long period from late 1940s to early 2010s.

Controlling for various factors, including period and country fixed effects, his regression results point to a much larger effect of premature de-industrialization on manemp than on realmva. For a representative country with median population in the sample (27 million), the manemp peaks at much lower income levels than realmva. The manemp starts to fall after peaking at about 20% at an income level of $5500, while realmva peaks much higher and at a much later stage (in fact at $70000 per capita income). Since the relative price of manufacturing declines as countries get richer, the nommva peaks earlier than realmva.

His model also points to a strengthening of the premature de-industrialization trend among economies since the 1990s. For the representative economy, since 1990 the share of manufacturing employment tends to peak at earlier income levels and at a lower rate.  

The same trend is observed for manufacturing output in recent decades.

Interestingly, Prof Rodrik finds that these trends are less strong for countries, especially from East Asia, who have had a comparative advantage in manufacturing.

These trends can be possibly explained by a combination of two arguments. The demand-side argument is that consumption preferences shift away from goods and towards services as incomes grow. This would cause a shift away from manufacturing in both employment and value added. The supply-side argument is that in view of technological progress and its impact on manufacturing productivity, the elasticity of substitution of labor between manufacturing and other sectors is less than one. However, while this causes the employment share to decline, the share of value added keeps rising. 

Corporate weakness and rising NPAs in India

As we enter Budget fortnight in India, two more signs that a transition to higher economic growth trajectory may be some distance away. First, corporate outlook, a pointer of underlying aggregate demand conditions, as reflected in their earnings data does not look promising,

For the three month period ended December 2014, India Inc’s profit growth has been the worst in five quarters, with the aggregate net profit of 2,941 companies declining 16.9%. Even after adjusting for one-offs (or extra-ordinary transactions), it is down 6.3% over the year-ago period... Sales growth is also the weakest in at least 12 quarters. For the Sensex companies, the reported net profit is down 6.5% year-on-year, its weakest show in six quarters, on a 2.2% decline in sales... On aggregate basis, Sensex profit was 7.5% lower than estimates... FMCG companies witnessed a dismal volume growth of 3-7% due to delay in recovery of urban discretionary demand... Operating profit margins of 1,992 manufacturing companies in the sample were down 100 basis points year-on-year and 140 basis points sequentially, largely due to decline in sales and a rise in employee and power and fuel expenses. 

 Second, BS also points to a rise in gross NPAs among public sector banks, except for SBI,

Barring State Bank of India, most public sector banks reported a sharp rise in bad loans in the quarter ended December, 2014... bad loans of over Rs 24,000 crore were added to already heavy kitty of stressed assets, and public sector banks’ (PSBs) share in it was a staggering Rs 21,466 crore... Banks are likely to see a spike in loan restructuring as the window for getting regulatory leeway in terms of lower provisioning closes on March 31 this year. In the nine months of the current financial year, gross NPAs worth Rs 51,252 crore were added. Thus, outstanding portfolio of bad loans of listed banks was Rs 4, 85,000 crore by the end of December 2014... Rating agency ICRA has indicated that the gross NPAs at system level would breach its earlier estimate of 4.2% by March 2015. It could be around 4.3%.

I have told this story earlier. Aggregate demand remains subdued in the face of inflation-induced decline in purchasing power. Rural demand, a major contributor to aggregate demand in the high growth 2003-08 period, was propped up by both the NREGS employment program and the gradual increases to Minimum Support Price (MSP). Without commenting on its merits, their recent scaling back is certain to adversely affect demand. The resultant downward pressure on top-line growth and profitability of corporates, who are already reeling from debt-laden balance sheets, would discourage new investments. The distressed balance sheets of credit suppliers are only a second order problem. 

The age of negative interest rates

Nothing captures the consequences of the obsession of world'a major economies with monetary policy fixes to their real economy problems better than this graphic which shows the five year sovereign debt of six countries trading at negative yields.

In other words, investors are paying to hold the debt of these countries. Fundamentally, in a deflationary environment, lenders can make money even with negative interest rates. Further, if market expectations are for further decline in yields, investors can make money by buying even negative yielding bonds as long as their prices keep rising.

The ECB's big bazooka decision to purchase 60 billion euros worth sovereign bonds every month for a prolonged period has jolted central banks outside the eurozone to respond to its potential vulnerabilities. Faced with a weak eurozone and the potential for a break-up of the currency union, speculators have been piling into safer assets of economies like Denmark and Switzerland with the hope of making large profits if those currencies appreciate. Given this and the prevailing deflationary environment, the risks are mainly two-fold - appreciation of currency and accumulation of bad quality assets.

The SNB's decision in mid-January to revoke the euro-franc peg, itself put in place in September 2011 to stem an appreciating currency, was motivated by growing apprehension about the riskiness of rapidly rising stock of eurozone sovereign bonds. The result of revoking the peg was that Swiss franc appreciated over 15% overnight. In order to mitigate the adverse impact on the currency, the SNB simultaneously lowered what it costs lenders to keep money at the central bank from minus 0.25% to minus 0.75%. In contrast, Denmark, which has pegged the krone with euro, appears to believe that the negatives from currency appreciation outweigh the threats from accumulating euro-zone assets. Accordingly, since January the Danish central bank has spent about $24 bn buying euro assets and has lowered rates four times to minus 0.75% on commercial lending.

Sweden and Finland are the latest entrants to the negative interest rate club. The former lowered the benchmark interest rate, the rate at which Swedish commercial banks can take out loans from the Riksbank to minus 0.1%. Last week Finland raised $1.14 bn in a five-year bond auction at minus 0.017%, becoming the first nation in the region to pay negative rates on its debt. Apart from stemming currency appreciation, especially important for countries deeply dependent on exports, negative rates are also aimed at encouraging companies and individuals to invest and spend more and possibly stoke inflation.

It is not just countries that are seeing negative interest rates. Nestle's two year corporate bond, which is due to mature in October 2016, touched the negative territory last week. The eurozone government's austerity programs (and resultant lower deficits) and ECB's sovereign bond-buying program have shrunk the pool of government bonds available for financial institutions (which need safe bonds as collateral for short-term borrowing), forcing them to turn to blue-chip corporate debt. The stock of negative yield sovereign bonds have risen to $3.6 trillion or 16% of global sovereign bonds. See also this and this for more on negative interest rates. 

Interesting project finance deals from 2014

Impressive compilation of project finance deals from 2014 in the World Finance magazine. A summary of few interesting ones.

1. Off-load construction risks and refinance the commissioned project. The 95 km Saltillo-Monterry highway was constructed by CAMS, a wholly owned subsidiary of Isolux Infrastructure Netherlands BV, the power and transportation construction and management arm of infrastructure major Grupo Isolux Corsan, through bank-syndicated loans. The construction was badly delayed, leading to renegotiations, including extending the concession period to 45 years. The road was opened to traffic in phases between 2009-11. In 2013, after protracted re-balancing of the bank loans, CAMS launched two bond-issuances to refinance the project through project bonds - a senior bond maturing in 2037 and carrying an inflation-linked fixed interest rate of 5.9% and a much larger sub-ordinate issue maturing in 2039 and an inflation-linked fixed interest rate of 8%. The project though remained on the balance sheet of Isolux and its O&M is being managed by Isolux's in-house team.

2. Construction and asset management are qualitatively different types of activities, requiring both different sets of concessionaires and financiers. Metro da Sevilla is the 18.1 km metro-line that is the only mass rail transit system servicing Spain's fourth largest city. The line which connects 21 stations was awarded as a private design, build, finance, operate, transfer concession in 2003 to a consortium of construction contractors and its construction was completed in 2009. Once construction was completed, the tenure of Spain's first privately developed and operated metro rail concession was re-negotiated in 2009 and extended till December 2040. In 2014, the Metro da Sevilla was taken over by a consortium led by Globalvia, one of the world's leading infrastructure management companies, in a 634 million euros deal which was financed by equity and three senior debt tranches with European Investment Bank (EIB). The concession has revenue streams that combine availability-based payments and traffic-linked income.

3. Long-term loans by the national infrastructure lending institution (say, IIFCL) with the condition that the borrower must float bonds once the project is commissioned. This would, apart from optimizing the cost of capital would also enable the FI to free up its loan book and move on with further lending. The Sao Paulo Gaurulhos International Airport was being operated by Infraero, the 100% government owned agency, which off-loaded 51% stake in February 2012 for BRL 16.2 bn to a consortium Invepar-ASCA for maintenance and expansion of the airport for a period of 20 years. BNDES gave a loan for the first phase of the project with this condition. BNDES encourages its lenders by offering them more favorable conditions (eg amortization schedule) than if the bonds were not issued.

4. Leverage sovereign wealth funds to invest in infrastructure. Wessal Capital, a joint venture of five SWFs - Morocco, Kuwait, UAE, Qatar, and Saudi Arabia - established at the Moroccon government's initiative, has amassed $3.3 bn in equity capital to invest in transformational projects to create destinations and promote tourism in Morocco. Its first project, Wessal Casablanca Project, involves the regeneration of a 12 hectare harbor area and the historic old-town Medina of Casablanca through a $700 m PPP, to be completed in 5 years. It will feature world-class tourism infrastructure and a marina with comprehensive cruise ship terminal. Wessal's Capital's next project is the redevelopment of Rabat City.

5. Deployment of PPPs in social sector projects. Greece's Attika Schools PPP project, which draws heavily from UK's Building Schools for the Future PPP program,  involves the design, build, finance, operate, and maintenance concession for 24 schools for a period of 27 years at a cost of 110 million euros. The 24 schools were split in two packages of 10 and 14 schools respectively so as to mitigate concentration risks and promote competition. Though the concessions were awarded in 2010-11 to ATESE and J&P Avax, it was renegotiated in the aftermath of the crisis and achieved financial closure in Q2 2014. The project draws funding from the EU's innovative city infrastructure funding tool, JESSICA, which is an initiative of European Commission, EIB, and Council of Europe Development Bank (CEDB). JESSICA aims to correct market failure by investing in sub-commercial terms to support viable urban projects that would not have otherwise attracted sufficient private investment.

6. PPP in urban transportation infrastructure. In 2013, in a $720 million deal, Rutas De Lima was granted a 30 year toll concession for construction, betterment, expansion, conservation, and O&M of 115 km of the three main highways incoming to Lima. Apart from ensuring more effective transportation connectivity to Lima, its specific objective was to improve traffic and road conditions, service standards, and road safety. The project will be financed by a combination of bank loan tranche (for capex financing and whose repayment will begin more than 1.5 years after project financial closure); a local currency denominated fixed rate bond tranche to finance immediate capex and investments at financial closure' and an inflation-linked local currency denominated tranche to be disbursed based on capex and investments chronogram.

India's savings deficit

Can India emulate China's quarter century long episode of near double-digit growth rates? There are compelling reasons to the contrary, none more important than the following two graphics. The first graphic shows the steep differential between the two countries' gross domestic savings and gross fixed capital formation respectively.

China's spectacular growth story has been underwritten by the country's high savings rate, which rocketed beyond 50% of GDP in last decade. Its gross domestic savings rate today is almost twice as large as India's and its gross fixed capital formation is nearly twenty percentage points higher. Further, even as India's savings rate has been declining, that of China shows no signs of abating. Given the vastly different contexts, it appears unlikely for India to come anywhere close to the savings and investment rates achieved by China.

The second graphic shows how in case of India the fall in gross domestic savings and resultant decline in gross fixed capital formation coincided with the transition to the current lower growth trajectory. 

This clearly illustrates why a recovery to a higher GDP growth trajectory requires an increase in the country's savings rate from its 2013 low of 28% to its 2007 peak of 34% of GDP so as to support an investment rate in the mid-thirties. The sharp rise in savings in the 2003-08 period came on the back of a sharp rise in private corporate savings, which nearly doubled during the period. But given the debt-laden corporate balance sheets, a recovery of corporate savings to its peak rate of 8-9% of GDP appears unlikely in the foreseeable future.

Even the current savings rate figure is deceptive since the share of household savings being locked up in illiquid and unproductive investments like real estate and gold has grown in recent years. This shrinks the pool of investible savings available.

So here is the challenge. High growth rates cannot be sustained without high investment rates. But high investment rates in turn requires high domestic savings rate. The alternative of sourcing foreign capital runs the risk of assuming large current account deficits which leaves the country vulnerable to sudden-stops and capital flight. There are no easy answers. 

More on India's manufacturing sector challenge

I had blogged earlier about the headwinds from technology induced labor market disruptions and structural changes in manufacturing sector that Indian economy will have to navigate. In this context, Tim Taylor points to the January 2015 issue of ILO's World Employment and Social Outlook which has a few interesting stats.

The report describes many people as holding jobs in the "vulnerable employment" sector - or "own-account work and contributing family employment". It finds that in 2014, 75.6% of the workforce of South Asia worked in "vulnerable employment", marginally smaller than the 76.6% in Sub-Saharan Africa, and far higher than elsewhere.

It also dwells on the issue of premature de-industrialization, as reflected in this graphic which shows that manufacturing's share of employment has been peaking much earlier among the latest entrants into the global manufacturing supply chain.

This assumes great significance for India, which has recently staked its growth behind manufacturing. In fact, apart from agriculture, manufacturing is expected to have the slowest employment growth rate among all sectors in the 2014-19 period.

In fact, evidence from 2000-13 from across countries shows that manufacturing's share of employment has either declined or been stagnant even during periods of growth acceleration.

In the 2000-13 period, the share of non-routine manual occupations has declined sharply in East and South Asia, whereas that of non-routine cognitive occupations has risen more than that of routine occupations in South Asia.

However, going ahead, a continuation of this trend will depend on the quality of workers joining the labor force. It is here that India's pathetic learning levels are a cause for great concern. 

The adverse selection problem with PPPs

Governments across the world see public private partnerships (PPPs) as a means to tide over their fiscal constraints and substitute for public spending. The government in New Delhi is no different. This view of PPPs is misplaced and is most likely to result in their failure. I have written about it here arguing that PPPs are effective when there are real efficiency gains to be had from involving private partners.

In normal times, creditors provide the most rigorous due diligence on projects. Since creditors are foremost concerned about repayment, their incentives are aligned towards ensuring that credit is channeled into financing only commercially viable projects. Such projects have a credibly guaranteed revenue stream to repay the project debt.

But this disciplining power of credit breaks down during the good times, especially during a credit boom. In an environment of cheap and plentiful credit, creditors go in pursuit of yield, assuming ever greater risks. This weakens the screening mechanism that distinguishes the commercially viable projects from the rest. Project developers are encouraged to peddle grandiose projects with large risks and doubtful commercial viability. Credit gets mis-allocated into projects of doubtful utility and commercial viability.

This is a classic case of adverse selection. PPP projects which otherwise would not have achieved financial closure, leave aside commercial break-even, find lenders when the disciplining powers of credit breaks-down as a credit bubble inflates. They get re-negotiated when the bubble bursts. This should not be seen as a symptom of deficient PPP plumbing or regulatory failures. These projects were never suitable for PPPs, should either never have been taken up or have been financed by public spending.

Accordingly, the re-negotiations in India's national highway toll road and ultra-mega power projects due to unrealistic traffic estimations and low-balled tariffs are less a problem of policy failure and more the manifestation of adverse selection. 

The case for macro-prudential measures to limit financial vulnerability

Kristin Forbes, Marcel Fratzscher, and Roland Straub have a new paper where they analyze capital flows management (CFM) measures in 60 countries during the 2009-11 period. They define two types of CFMs - capital controls (or restrictions on cross-border financial activity that discriminate based on residency) and macro-prudential measures (which do not discriminate based on residency but relate to cross-border or foreign currency exposure and lending).

Examining the impact of CFMs on their various targets - limiting exchange rate appreciation, reduce portfolio inflows, reduce inflation, and reduce financial fragility - they find mixed evidence,

The results indicate that certain CFMs can accomplish specific goals—especially in terms of reducing financial vulnerabilities—but most CFMs are ineffective at accomplishing other stated goals. More specifically, macroprudential measures related to international exposures can significantly improve measures linked to financial fragility, such as bank leverage, inflation expectations, bank credit growth, and exposure to portfolio liabilities. Increased controls on capital inflows can reduce private credit growth (although this effect, as well as that for portfolio liabilities, appears to fade and reverse after six months). 

CFMs, however, do not appear to have a significant effect on most other macroeconomic variables and financial market volatilities over the short and medium-term, including on equity indices, inflation, interest-rate differentials, or the volatility of exchange rates, portfolio flows, or interest-rate differentials. CFMs have limited effectiveness achieving two of their primary goals: reducing exchange rate appreciation and net capital inflows. One type of CFM—removing controls on capital outflows—can yield a significant but small depreciation of the real exchange rate (with a maximum depreciation of less than 2.5% over four months relative to the counterfactual). “Major” changes in capital controls which received more attention from investors are more likely to affect portfolio inflows, although major changes in inflow controls can also cause a significant increase in capital flow volatility and translate into no consistent, significant, or economically meaningful impact on the real exchange rate.

More evidence on why authorities in emerging economies should deploy macro-prudential instruments to limit exposure to external borrowings, especially short-term debts to specific sectors like real estate which inflate asset bubbles, and thereby minimize financial vulnerability.

The latest example of the problems arising from free capital inflows is Poland, which had allowed its citizens to take mortgages in foreign currencies. Attracted by the low Swiss interest rates and the apparent resolve of the Swiss central bank (SNB) authorities to prevent the currency's appreciation, many Poles took mortgages in franc, mainly from foreign owned banks, to finance their homes. The Polish Financial Authority estimated that in 2013 franc loans formed a third of all Polish mortgages. These people have been devastated by the SNB's decision last month to abandon the currency floor with euro which resulted in the one-day 23% appreciation of the Swiss franc against the euro. 

Industrial Policy in Oil Exploration

Since 2008, US oil production has risen spectacularly by nearly 80 percent, on the back of oil and gas extracted from underneath shale rock formations. This development which promises to usher energy independence for the US has been enabled by two breakthrough technologies - hydraulic fracking and horizontal drilling.

However, as Eduardo Porter reports, these technologies originated from US industrial policy in the aftermath of the 1973 Arab oil embargo,

Congress passed the Energy Reorganization Act of 1974, creating the Energy Research and Development Administration — which would soon become the Department of Energy. This kick-started a period of heavy government investment in research and development to recover gas from shale. The agency provided funds for “directionally deviated” drilling, a precursor to the horizontal drilling used today. It subsidized the development of polycrystalline diamond compact bits to cut through the shale. It performed the first big hydraulic fracturing. Energy Department labs created a multi-well fracking test site. Research at the Sandia National Laboratories into underground imaging — based on microseismic monitoring once used to detect coal mine collapses — was critical to map fractures and position wells.